On December 11, 2008, Bernard Madoff, former NASDAQ chairman, was arrested and charged with a securities fraud. The $50 billion of losses, if proved, would make it the biggest Ponzi scheme in history. 
Madoff’s scheme was typical of a Ponzi in its structure – paying returns to investors out of the money paid by subsequent investors rather than from profit. Somewhat unique, however, was rather than offering suspiciously high returns to an indiscriminate group of investors, Madoff offered modest, but steady returns to an exclusive clientele. Madoff’s scheme was also unique in that many of his victims invested in his scheme indirectly through hedge funds. Everything was going well until the general market downturn of 2008 motivated a larger than usual number of investors to cash out their positions. With little actual liquidity, the scheme collapsed, leaving many investors with economic losses.   
Although the tax rules surrounding this type of fraud are complex, the ability to regain some of those losses, via the theft loss deduction, is likely to be available. For investors who are subject to federal, state, and local income tax, the theft loss deduction can have a cash value equal to almost 50% of the tax loss. Assuming that investigators establish that the losses are predominantly the result of a Ponzi scheme, the IRS is likely to concede that some portion, or all, of the losses qualify as allowable theft losses for tax purposes.

• Is a deduction of ordinary income (and is not subject to the $3,000 annual limitation that applies to capital losses).

• To the extent that the allowable theft loss exceeds the investor’s total income for the year of deduction, may be carried back to the prior three years (resulting in the refund of taxes paid in prior years) or carried forward for up to 20 years (reducing future tax obligations)

Amount of Theft Loss Deduction
The starting point for calculating the amount of the theft loss is the tax basis of the stolen assets. 
A taxpayer’s basis in taxable accounts generally consists of the following: 

• The amount of any capital invested;
  
  
• Increased by: the amount of any taxable income properly credited to the investor’s account in prior years;
  
  
• Reduced by: the amount of any funds returned to the taxpayer; and
  
  
• Further reduced by: the amount of any claim for reimbursement for which a reasonable prospect of recovery exists. 

It should be noted that a taxpayer’s basis in IRAs, 401k(s) and other tax deferred accounts generally is zero. Thus, despite the taxpayer’s economic loss attributable to such nontaxable accounts, a theft loss deduction is not available in those circumstances. 

Timing of Theft Loss Deduction
Under the tax law, a taxpayer must report the amount of allowable theft losses in the year the theft is discovered. This would likely mean that investors will have to report the loss on their 2008 tax returns. However, Treasury regulations bar the loss if it is subject to insurance or reimbursement and states that the year of the loss is the year in which the amount of reimbursement is ascertained with reasonable certainty. Only the portion of the loss that has a reasonable prospect of recovery is nondeductible; any portion of the loss that has no reasonable prospect of recovery is deductible in the year discovered. 

In addition to the potential recovery of assets from the Madoff bankruptcy estate, several other potential sources of recovery should be addressed by affected investors: 

• SIPC recovery. Investors may also have access to funds from the Securities Investor Protection Corporation (SIPC), a government organization which offers assistance to investors of failed brokerage firms. Investors may receive a maximum of $500,000.  Currently, it is unclear how to treat any potential recovery from SIPC. Accordingly, the IRS may take the position that the amount of loss is not currently known and can only be claimed in some later year.
  
  

• Third-party lawsuits. In addition to the lawsuits that have been filed against Madoff, lawsuits have also been filed against the managers of the so-called “feeder funds” who placed investor money with Madoff, as well as the auditors of such funds. And at least one investor has filed a suit against the SEC itself. Although it may take years for these suits to work their way through the court system, the potential amount of recovery from such suits should be addressed. 
  

It should be noted that filing claims against one or more of these parties may strengthen the potential IRS argument that a reasonable prospect of recovery exists, which could potentially delay the timing of the theft loss deduction. 

Recovering Prior Taxes Paid on Fictitious Income
Due to Madoff’s lack of recordkeeping, it is impossible at the present time to determine the amount (if any) of income that should have been reported to investors in prior years. To the extent that some or all of the income reported to investors in prior years was fictitious, it is unclear whether the amount may be included in the taxpayer’s basis for purposes of determining the amount of the theft loss. 

To protect against the possibility that the IRS may take the position that all income was fictitious and therefore does not give rise to tax basis (which may be included as part of the theft loss deduction), investors should consider filing amended returns seeking a refund of the taxes paid as such income. As a general rule, investors can only seek refunds for tax returns filed within three years of the date of the refund claim. For example, for investors who file their returns on April 15 each year, the refund deadline for the 2005 tax year expires on April 15, 2009 (three years after the April 15, 2006 filing date of the 2005 return). 

Unfortunately refund claims for such timely filers are already barred for all tax years prior to 2005, so investors who had money with Madoff in earlier years may already be time-barred from getting refunds on taxed paid on the fictitious income. 

At some point, the IRS may begin to issue guidance on the extent of allowable refund claims on fictitious income reported to investors. In the meantime, investors should consult with their tax advisor to avoid allowing any refund year to become barred by the passage of time, even if the refund claims must be filed on a protective basis. Cohen & Company’s tax department is experienced in the tax consequences of theft losses. If you have been affected by the Madoff scheme or other Ponzi schemes, please contact Natalie Takacs at (440) 205 - 4814 or ntakacs@cohencpa.com to review the tax consequences of your facts and circumstances.

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